Abstract

Liquidity risks are endemic to banks, given the maturity transformation they undertake.
This gives rise to risk of bank runs, the first line of defence against which
should be appropriate liquidity policy of banks. Nonetheless, solvent banks
can face liquidity difficulties at times of stress, necessitating liquidity
support. The traditional role of the lender of last resort (LOLR) is to avoid
unnecessary failures that could threaten systemic stability, while ensuring
that there are suitable safeguards for central bank balance sheets and that
moral hazard is minimised. The sub-prime crisis has shown that traditional
models of bank liquidity risk and of LOLR require revision, as was already
apparent to a lesser extent in the Long-Term Capital Management (LTCM) episode.
Funding risk now interacts with market liquidity risk to create difficult challenges
for central banks. The LOLR has had to adapt radically, for example, in terms
of lending to investment banks, taking lower-quality collateral and lending
at longer maturities. Central banks have also been challenged by difficulties
in maintaining confidentiality of support and by the interaction of these problems
with low levels of deposit insurance.

1. Introduction

This paper seeks to assess the importance of liquidity in financial crises and how
the authorities may deal with it. It starts from the concept of bank runs –
whereby the nature of banking means that solvent banks may at times be subject
to panic runs and consequent illiquidity – and their ubiquity in most
crises to date. Contagion may arise via credit risk linkages to other banks.
This is a problem of ‘funding liquidity’. It then considers the
authorities' response to crises in terms of LOLR – illustrated by
historical examples – and the evolving ‘doctrine’ of LOLR.

The paper then goes on to assess how liquidity problems during the current crisis
have differed from the past. During this crisis the authorities have had to
adapt their LOLR policy to a crisis which is not merely one of ‘funding liquidity’
but also of ‘market liquidity’ (Davis 1994; IMF 2008), while contagion
has occurred more via market prices and less via credit risk (Adrian and Shin
2008) and new ‘amplifiers’ of financial instability have become
apparent (Brunnermeier, forthcoming). The LOLR has had to adapt radically,
for example, in terms of lending to investment banks, taking lower-quality
collateral and lending at longer maturities. It has also been challenged by
difficulties in maintaining confidentiality of support and the interaction
of these problems with low levels of deposit insurance.

2. Liquidity in Financial Crises

Liquidity risk, in general, is the risk that an asset owner is unable to recover
the full value of their asset when sale is desired. One type of liquidity risk
is funding risk, which relates to the ease with which one can raise money by
borrowing using an asset as collateral. Liquidity risk of this type has always
played a key role in banking crises. This section provides a benchmark against
which to compare previous episodes to the sub-prime crisis.

Bank assets – particularly loans – are by their nature illiquid and long-term,
and subject to imperfect information, while liabilities are mostly liquid and
short-term. These short-term liabilities are conceptually a means of disciplining
bank managers via the threat of bank runs, as they help to ensure that bank
managers take depositors' interests into account by not taking excessive
risks in their choice of asset holdings (Kaufman 1988). But depositors'
monitoring of projects is likely to be prone to error, making banks vulnerable
to ‘overdiscipline’ (and possibly runs on solvent banks), leading
to socially wasteful liquidation of projects. Owing to the fire sale problem
– that is, the inability to realise assets at full value owing to asymmetric
information – illiquid banks can rapidly become insolvent.

Once one bank has experienced a run, there is the possibility of contagion, with
runs on other banks. Depositors may react either to balance sheet similarities
with the failed institution under uncertainty and asymmetric information (Morgan
2002), or to perceived counterparty exposures with the failed bank. Contagion
could, in turn, impact on the wider economy via monetary contraction, or credit
contraction owing to the difficulty individual borrowers may have in establishing
new credit relations with a different financial institution when their bank
fails (Freixas,
Giannini et al 2000). Note, however, that widespread bank
runs need not imply contagion. An alternative possibility, as was arguably
the case with the banking crises in Scandinavia in the early 1990s, is that
there is a macroeconomic shock of such magnitude that many banks become simultaneously
insolvent.

There are various models of bank runs. The best known is the Diamond and Dybvig (1983)
model, in which banks provide liquidity insurance to risk-averse depositors.
Normally, the demand for repayment by depositors is predictable and can be
catered for by a low level of liquid assets; however, if the bank is forced
to sell its illiquid assets in a ‘fire sale’, then it may not realise
sufficient cash to cover all of its deposits. Then some depositors may run,
if they suspect other depositors will also do so, as they fear being last in
the queue for cash (that is, there is a coordination problem). This pattern
may lead to the insolvency of a potentially sound institution.

The Diamond-Dybvig model assumes that bank runs are purely random events. Alternatively,
Chari and Jagannathan (1988) suggest that adverse information leads to panics
– that is, systematic risks are inferred from what may be idiosyncratic.
Jacklin and Bhattacharya (1988) focus on the role that information of depositors
may have on the quality of bank assets. Gorton (1988) saw panics occurring
mainly in recessions, which confirms the adverse information hypothesis, since
panics occur close to the period when business failures are most widespread.

Runs are traditionally assumed to take place among retail depositors, but large wholesale
depositors are increasingly important. Wholesale depositors are generally better
informed and less likely to be covered by deposit insurance and (as discussed
below) banks are increasingly dependent on wholesale funding. The interbank
market is a key locus of runs in recent years, including, for example, the
failures in the United States of Franklin National in 1974 and Continental
Illinois in 1984.

Of course, the systemic importance of interbank markets has increased because of
recent trends in financial innovation. For example, there is a growing need
for liquidity owing to growth in international trading and transactions –
notably, over-the-counter (OTC) derivatives can give rise to unexpected liquidity
demands – and also of large-value interbank payment systems using real-time
gross settlement (RTGS). Nevertheless, although there have been individual
bank failures, the domestic interbank markets of the advanced countries have
historically been fairly robust.

The international interbank market has been a major focus of liquidity crises, as
in the Asian crisis of 1997. Bernard and Bisignano (2000) highlight a number
of features of the international interbank market that contribute to this.
They include, first, the typical lack of security (collateral) and low levels
of information gathering. These may in turn be linked to moral hazard via implicit
guarantees by central banks for the interbank market's functioning. The
existence of the interbank market may also lead banks to underinvest in liquidity.
A range of banks with low credit quality (as in east Asia up to the crisis
of 1997) may operate in it so long as lenders believe the implicit guarantees.
The international interbank market is typically subject to quantity and not
price rationing of credit, due to low levels of information on credit risk.
The short maturity makes withdrawal easy and, more generally, the market is
vulnerable to sudden increases in credit rationing during periods of stress,
as a result of adverse selection and moral hazard problems. These shortcomings
give rise to a potential for contagion and global transmission of shocks.

Theory has begun to catch up with this shift in importance from retail to wholesale
runs.[2]
For example, Allen and Gale (2000)
highlight the possibility that systemic risks in the interbank market can vary with
the structure of creditor relations. Most risky is a structure with unilateral
exposure chains among banks, while there is less risk of contagion when all
banks lend to each other, as the effects of shocks are less concentrated. In
between these two types of structures is a tiered structure of money centre
banks on which other banks rely (Freixas,
Parigi and Rochet 2000).

3. Liquidity Policy of Banks

Banks can protect against liquidity risk. Most obviously this can be done by holding
a significant proportion of liquid assets (a so-called net defensive position).
Cash is then available to be used immediately to answer liquidity needs, while
government securities can be used readily as collateral. However, banks seek
to avoid holding liquid assets given the cost in terms of lower profitability,
the low frequency of crises, limited liability of shareholders, and the safety
net, as discussed below. There have been major declines in asset liquidity
over recent decades; for example, in the United Kingdom, banks' liquid
assets were 30 per cent of the total in the 1950s, but today are only 1 per
cent (Goodhart 2007).

Banks can dissipate withdrawal risk by diversifying funding sources. This is liability
management, which aims to ensure the continuity and cost effectiveness of funding
(Greenbaum and Thakor 2007). There are three key issues. The first is to ensure
enough diversification to reduce liquidity risk among, for example, certificates
of deposit, eurodollars, repurchase agreements (repos), subordinated debt and
contingent credit facilities from other banks as well as interbank, time and
demand deposits. Securitisation is a further instrument for liability
management.[3]
The second is to ensure the appropriate mix of traditional deposits and investment
products. Deposits typically incorporate services, have pay-offs that are insensitive
to the fortunes of the intermediary, and are for small/uninformed users who
are insured, so their demand for such deposits is usually stable. Investment
products are typically risk-sensitive, have pay-offs that vary with the intermediary's
performance, involve monitoring, and are for large/informed users, so their
demand for these products may be more volatile. The third is the choice of
maturity structure – duration matching affects the degree of liquidity
risk, but may also reduce flexibility.

A further backup is holding adequate capital to ensure that creditworthiness is maintained
in the face of adverse shocks. However, experience has shown that adequate
capital according to current rules is not always sufficient to ensure liquidity
problems are avoided, as solvent banks can suffer runs due to illiquidity.
Regulation of bank liquidity is less developed than for capital, and not subject
to international
agreement.[4]
Compulsory reserve requirements are one policy for ensuring that banks hold liquidity,
although their main purpose is for collateral in central bank monetary operations,
overall monetary control and payments system functioning. Reserves are not
readily available to meet a liquidity spike, especially if there is a mandatory
minimum ratio. There is also typically qualitative oversight of liquidity policy
in the context of prudential supervision (Pillar 2 of Basel II).

Goodhart (2007) argues that generous provision of liquidity by central banks, in
normal times and times of crisis, has made banks careless in liquidity risk
management, with low liquid assets and reckless liability management. The banks
are seen as taking a liquidity ‘put’ with the downside risk of
liquidity crises covered by the central bank. It is to the LOLR, that is, liquidity
policy in times of emergency, that I now turn.

4. The Lender of Last Resort (LOLR)

I now go on to outline the doctrine of the LOLR, citing examples from history which
are relevant to each point. These are the ‘accepted wisdom’ which,
I argue, is called into question by the sub-prime crisis.

4.1 The nature and history of LOLR

The LOLR is generally described as an institution, such as the central bank, which
has the ability to produce, at its discretion, currency or ‘high-powered
money’ to support institutions facing liquidity difficulties and to create
enough base money to offset public desire to switch into money during a crisis.
This delays the legal insolvency of an institution and prevents fire sales
and calling of loans.

The LOLR operation is by discretionary provision of liquidity (against collateral)
to an institution or market to offset an adverse shock that creates an abnormal
increase in demand for liquidity. The aim of the LOLR is to prevent illiquidity
at an individual bank from leading to insolvency (owing to the fire sale problem,
as defined above). Thereby it may avoid runs that spill over from bank to bank
(contagion, as defined above), which may in turn lead to an impact on real
wealth and GDP that would not occur in the absence of the panic. LOLR needs
to act rapidly before illiquidity becomes insolvency and before such a panic
begins to take hold.

I first briefly note historical developments before World War II. Although Thornton
wrote first about the concept in 1802, the genesis of LOLR in practice is often
thought to be the aftermath of the Overend Gurney crisis of 1866, when the
Bank of England failed to prevent a crisis, which was subsequently reflected
upon by Bagehot (1873). Put simply, he argued that the central bank should
lend freely at a penalty rate against good collateral. Furthermore, the central
bank has to act in the public interest and not solely its private interests,
as the Bank may have done in 1866. The classic operation of LOLR was reflected,
for example, in the rescue of Barings Bank by the Bank of England in 1890,
as well as in panics during 1878 and 1914 (Bordo 1990). As noted by Goodhart
(1988), these events took place during the period of the Gold Standard when
the central bank was the institution maintaining convertibility of the currency
with gold, which made it a natural LOLR, albeit generally also involving other
banks in rescues given the limitation of its own capital
base.[5]
Combined with uncertainty regarding rescues, the ‘club’ of banks in a
national market would protect against moral hazard by policing behaviour of
counterparties, even in the absence of modern banking regulation.

Even after the demise of the Gold Standard, the key role of the LOLR has often been
considered to offset the risk of a monetary contraction, as in 1932 in the
United States. However, as argued by Kaufman (1991), its more recent operation
against a background of deposit insurance does not have this function, as a
general flight from the banking system to currency is unlikely. Rather, crises
tend to lead to a reshuffling of deposits between banks, and the LOLR seeks
to limit losses of wealth and GDP that would otherwise take place when such
reshuffling occurs.

Focusing now on more recent episodes and the current state of ‘doctrine’
in a modern financial system, LOLR intervention can be by direct lending (discount
window) or by open market operations, as well as by off-balance sheet guarantees.
Some argue that in an advanced financial system, LOLR should only be via open
market operations, since the market will direct liquidity to where it is needed,
and the risk of mispricing is avoided (Goodfriend and King 1988; Kaufman 1991). Such
a policy was clearly successful in the case of operations associated with the
spikes in liquidity demand in the Y2K and September 11 episodes, as well as
after the stock market crash of October 1987.

However, Goodhart (1999) argues that LOLR may require direct lending, not open market
operations, as market lending may fail to reach banks in distress whose failure
threatens the financial system. This motivated, for example, the rescue of
Continental Illinois in 1984, which was also thought to give rise to a risk
of contagion due to its widespread interbank lending links (179 banks were
thought to be vulnerable). In 1974 the Bundesbank let the Herstatt Bank fail,
while giving liquidity assistance to the market in line with Goodfriend and
King, but the consequence was a global breakdown of payment systems that almost
precipitated an international financial crisis (Davis 1995).

Instruments of such direct support can be the discounting of eligible paper (such
as government securities), advanced with or without collateral, and repos of
the institution's assets that the central bank is willing to accept. The
value of collateral should exceed that of the LOLR support. There should be
provisions for repayment and the provision of funds by the LOLR must be for
the short term only, allowing examination of the financial institution for
long-term viability. If there is default on LOLR loans, closure is needed,
or if the bank is too-big-to-fail, it should be nationalised with owners and
senior managers dismissed.

Generally, LOLR to date has been for banks and not for non-banks such as securities
houses. Reasons are that banks are more systemically important and also so
as not to weaken market discipline on less heavily regulated institutions.
This was one reason for the refusal of the United States to support Drexel
Burnham Lambert in 1989 (although
the Bank of Japan did save Yamaichi in the 1990s; see Nakaso 2001). Equally, prudent
investment banks, although dependent on wholesale funding, would typically
hold short-term assets, protecting them against liquidity risk.

4.2 Costs of LOLR

There are costs to having a LOLR (He 2000). The LOLR is supposed to aid illiquid,
but not insolvent, institutions (Humphrey and Keleher 1984). However, as noted
by Kindleberger (1996), in a crisis it is hard to distinguish illiquid and
insolvent banks, and a bank that may initially be illiquid can become insolvent.
Goodhart and Schoenmaker (1995)
note that banks generally face illiquidity when solvency is in question. Hence, liquidity
assistance may lead to support for insolvent institutions, with direct costs
for the central bank and fiscal authorities. Kaufman (1991) notes that the
US Federal Reserve System (Fed), for example, supported Franklin National in
1974 and Bank of New England in 1990, which both subsequently failed. Furthermore,
doctrine states that LOLR is not an appropriate policy alone in cases of simultaneous
macroeconomic shocks to solvency – such as in the contraction of GDP
in Finland in 1990 – which may require the fiscal authorities to recapitalise
banks.

As noted, beyond direct costs, the safety net reduces the incentive for banks to
hold liquidity, as risk is passed to the central bank (Goodhart 2007). It may
also facilitate uninsured depositors exiting a bank (Kaufman 1991). Most crucially,
LOLR increases moral hazard and consequent risk-taking, as well as weakening
market discipline.[6],[7]
Arguably, this is particularly the case for direct lending as opposed to open market
operations. It is widely argued that the long-term decline in bank capital
adequacy up to the 1988 Basel Agreement, as well as lower liquidity buffers,
resulted from moral hazard generated by the safety net.

Further costs are that, if offered to insolvent banks, LOLR support increases the
scope for forbearance. This is because it removes the pressure on regulators
to close failing banks promptly (especially if the regulator is a separate
institution from the central bank). If allowed to continue operating, banks
with negative net worth can cause major costs, as in the Savings and Loan crisis
in the United States in the 1980s. LOLR for the insolvent institution also
raises the difficulty of institutions being too-big-to-fail – some banks
can become ‘sure’ of rescue owing to their systemic importance,
and this is also reflected in ratings (again the rescue of Continental Illinois
was arguably the genesis of this).

A further cost is conflict with other policies. There may be conflicts with the monetary
policy regime, unless liquidity is fully sterilised (the LOLR action at the
time of the stock market crash in 1987 was seen as generating inflation). It
may also conflict with fiscal rules if there is a guarantee by the fiscal authority.

4.3 Minimising costs of LOLR

Doctrine maintains that minimising such costs requires that there be only support
for institutions whose failure entails systemic risk. The central bank must
ensure that banks have made efforts to gain liquidity support and all market
sources of funds have been exhausted. Equally, following Bagehot (1873), the
authorities should demand high-quality collateral and a penalty interest rate.
The former protects the central bank from credit risk and encourages the banks
to lend at lower risk (Goodhart 2007). The latter, along with harsh conditionality
(for example, liquidity restoration, restrictions on new business or on dividend
payments), ensures that the borrower only requests LOLR support as a ‘last
resort’. Bordo (1990) notes, however, that in 1974 the Fed offered Franklin
National loans at below market rates.

To further reduce moral hazard, doctrine states that the central bank should seek
a private solution before using the LOLR (from the creditors, other major banks,
etc). This has been the tradition in Continental Europe and indeed it is enshrined
in French law. In Germany, the private Likobank is intended to substitute for
the possibility of the central bank needing to undertake LOLR. On the other
hand, experience has shown that banks are increasingly less willing to play
a role in such rescues, owing to deregulation and international competition
(Goodhart
and Schoenmaker 1995). The Bank of England experience with the rescue of Johnson
Matthey in 1984 showed this. The wholly-private rescue of LTCM in 1998, however,
was a recent example of creditors being willing to mount a rescue – of
a hedge fund – without guarantee, showing that private rescues are still
viable in extreme cases, with suitable moral suasion by central banks.

The LOLR must also ensure that there is adequate information on financial institutions
and strict financial regulation; although Goodhart and Schoenmaker do not conclude
that there is a benefit to overall financial stability from the central bank
being the supervisor.

To avoid monetary conflict, the central bank must sterilise liquidity – otherwise
there is a risk of inflation, capital outflows and a collapsing currency (as
occurred in Indonesia in 1997; He 2000). This requires instruments be available
such as reverse repos, foreign exchange swaps and deposit facilities. There
is also a need for backup from the fiscal authorities if the rescued bank is
insolvent, otherwise the central bank may itself face solvency difficulties,
as in Finland in 1990 when the central bank saved an insolvent savings bank
and wiped out its own capital.

The central bank, according to doctrine, should reduce moral hazard by making access
to LOLR facilities uncertain – the market is not to take for granted
the action to be followed by the authorities, with decisions to be made on
a case-by-case basis. The Bank of England has, for example, allowed banks such
as Barings in 1995 to fail, since it was judged to be non-systemic. Ambiguity
may be heightened by secrecy as to whether LOLR is taking place, as with the
small UK banks that were rescued in the early 1990s, so as to avoid wider loss
of confidence and ultimately underwriting the whole banking system (George
1994). Confidentiality can also help to prevent knowledge of LOLR support from
giving rise to panic, a rise in borrowing costs or a loss of reputation to
the bank in receipt of LOLR.

He (2000) suggests that central banks could nevertheless spell out necessary but
not sufficient conditions for LOLR (for example, a precondition of solvency
and exhausting available sources of funds) – thus reducing incentives
for unnecessary crises and giving incentives for stabilising private-sector
actions. This might also reduce risks of forbearance and political interference.
But ex ante
transparency may heighten the risk of runs, and give rise to moral hazard (The Economist
2008). There remains a strong case for ex post transparency
(that is, saying what has been done after the crisis has subsided, to ensure
accountability in the use of public funds).

Generally to date, LOLR has been in domestic currency (on the argument that banks
should be responsible for foreign exchange risk management). In this context,
there is the unresolved problem for cross-border banks (notably
in the European Union) of whether the home or host LOLR should play the largest role
in a crisis.

4.4 LOLR in systemic crises

So far I have discussed LOLR for a non-systemic problem. In times of systemic crisis
it may act differently (Hoelscher
and Quintyn 2003). This is a situation of panic, flight-to-quality and widespread
contagion. The aim is to reassure the public that financial disorder will be
limited and to stop panic runs, by public announcements and visibility. The
central bank may need to provide uniform support for all banks short of liquidity,
even if they are suspected to be insolvent, in order to protect the payments
system and the macroeconomy. Constructive ambiguity is no longer appropriate
(Nakaso 2001). Collateral and solvency requirements may be relaxed, at least
if there is a government guarantee. No penalty rates would be imposed as they
would worsen the panic. Also the central bank would need to suspend judgment
of which institutions are systemically important.

Emergency liquidity assistance in such cases is to be part of the overall crisis
management strategy involving the central bank, supervisors and the fiscal
authorities. It may require a general macroeconomic policy easing (for example, interest rate cuts) as a crisis
by itself constitutes a tightening of financial conditions. However, care is
needed to avoid inflation or an exchange rate collapse. There is an option
of imposing capital controls (as in Malaysia in 1997). Costs of such emergency
assistance policies can be sizeable. Hoelscher and Quintyn (2003) record that
liquidity support during the Asian crisis was 16 per cent of GDP in Indonesia
in the form of overdrafts from the central bank, and 13 per cent of GDP in
Malaysia from central bank deposits (which were,
however, repaid).

In a systemic crisis, there may also be a blanket deposit guarantee by the government,
as in Japan and Sweden in the 1990s, and the fiscal authorities will have to
bear the costs of bank recapitalisation. The overall fiscal costs of crises
will thus often far exceed the LOLR assistance – in Indonesia the overall
cost was around 50 per cent of GDP. This potential fiscal burden, in turn,
helps motivate the separation of regulation from central banks (Goodhart and Schoenmaker 1995).
It also underlines the point that liquidity assistance must not be a long-term policy
– it should be used to stop panics and buy time for evaluation of the
financial system. The government may need to recapitalise or close insolvent
banks in a long-term restructuring (as took place in Sweden and Finland in
the early 1990s). The LOLR is still needed in a systemic crisis if the credibility
of the deposit insurance scheme is lacking (or depositors fear delay in repayments)
– in which case the fiscal authorities may also need to guarantee the
central bank.

Having outlined liquidity risk, bank liquidity policy and the evolving doctrine of
the LOLR, I now go on to assess whether the current sub-prime crisis requires
our understanding of these concepts to be revised.

5. Recent Developments in Liquidity Risk

5.1 The sub-prime crisis and liquidity

I suggest that the understanding of the liquidity problems in the current crisis
requires theory to go beyond the Diamond-Dybvig (1983) concept of bank funding
liquidity risk, to encompass market liquidity risk and its interaction with
funding liquidity against a background of heightened credit risk (see also
IMF 2008). It also requires consideration of the impact of banks' policies
of marking to market, risk management and balance sheet management (Adrian
and Shin 2008).

Market liquidity risk can be defined as the ease with which one can liquidate a position
in an asset without appreciably altering its price. Institutions and markets
were shown to be much more closely integrated than in the past. Systemic market
liquidity problems were only apparent before the sub-prime crisis during the
LTCM crisis (IMF 1998; Davis 1999) – although in the
case of LTCM the banks were relatively unscathed. I first describe the build-up
to the sub-prime crisis, as well as the crisis itself, before considering relevant
liquidity risk
paradigms.[8]

Key developments in the period 2000 to 2007 include the accelerating shift by banks
from holding loans on balance sheet to relying on securitisation (which in
turn reduced the incentive to monitor loans). Banks held increasingly low levels
of on-balance sheet liquid assets and they undertook aggressive wholesale liability
management to maintain funding levels. Banks also attempted to shift risk to
off-balance sheet conduits and structured investment vehicles (SIVs) in order
to save capital under Basel I
rules.[9]
These shifts occurred in a context of low global interest rates, arising in turn
from high levels of global liquidity, which prompted a hunt for yield (for
example, via higher credit risk in structured products and sub-prime loans).
More generally, scope for securitisation (and the impression of liquidity it
gave), high credit ratings on asset-backed securities (ABS) and the seeming
precision of risk models based on inadequate data, may have lulled banks into
taking on more credit risk than they otherwise would.

By 2007 there was a growing realisation of potential losses on sub-prime mortgages
(that is, credit risk) as US house prices fell and defaults increased. These
loans had been widely packaged into ABS. Investors, concerned not only about
losses on the underlying assets but also lack of transparency as to how individual
ABS would be affected, began to sell them. Sales led in turn not just to price
falls but also market liquidity failure for the OTC markets for the ABS. As
prices fell, trading became difficult or impossible, even among the lowest
risk tranches of the relevant securities.

As noted by the European Central Bank (ECB 2008), price falls affected not only the
standardised instruments such as index-based collateralised debt obligations
(CDOs) but also the ‘bespoke’ structures that are not normally
traded but which are nonetheless marked to market. This link followed from
the fact that implicit prices for the latter are derived from the former. Furthermore,
Scheicher (2008) shows econometrically that, over and above concerns regarding
credit risk, there were significant concerns about market liquidity and the
lower appetite for risk in accounting for the fall in prices (the rise in spreads).
Such liquidity and risk-aversion effects are omitted from standard CDO pricing
models.[10]

This liquidity failure was aggravated by rising margin requirements, which limited
the freedom of speculative investors, such as hedge funds, and led them to
sell holdings of ABS. It was also worsened by the lack of risk capital allocated
to market-making in such products, due to the rise in volatility and lower
revenues to investment banks, which limited their ability to take risks.

The rush to sell securitised assets may also have been worsened by the effects of
price falls in the context of mark-to-market accounting on the capital of leveraged
institutions. Another factor was the reliance of some institutions on quantitative
techniques of trading and risk management that assumed continuous liquidity (IMF 2008).

As a result, long-term investors may have been constrained from taking contrarian
positions that could have renewed market liquidity due to excessive leverage
(for example, of hedge funds) and consequent credit restrictions in the context
of mark-to-market accounting (Palmer 2008). Monoline insurers, that provide
some credit guarantees to ABS and credit default swaps (CDS) themselves, also
came under financial pressure (BoE 2008).

Banks were also rapidly affected by the loss of liquidity in the market for securitised
loans. They had to mark to market ABS held on balance sheet, so price falls
affected their solvency. This was unlike banking crises in the past where loans
have typically been held at historic cost with no specific price. The fact
that a great many ABS were held in conduits and SIVs spread the contagion,
since these institutions require financing in the market for asset-backed commercial paper (ABCP). Doubts by
money market funds regarding the ABS held by the conduits and SIVs led to a
loss of liquidity in the ABCP market also, which meant that sponsoring banks
had to take the assets back on their balance sheets. The extensive holding
of US ABS by European banks and related conduits and SIVs spread the impact
internationally.

Meanwhile, traders' attempts to hedge, meet margin calls or realise gains in
safer or more liquid markets adversely affected liquidity in other markets
in a contagious manner. Market-makers in a range of markets were often unwilling
to trade at posted prices (IMF 2008) due to uncertainty, volatility and concern
about the risks of counterparty default.

The crisis has revealed new patterns in funding liquidity risk which stem from market
liquidity risks. Banks were unable to securitise the mortgages and other loans
they were issuing, owing to the collapse of the ABS market. They also experienced
calls on backup lines of credit for conduits and SIVs that were unable to issue
ABCP. Accordingly, banks hoarded liquidity in order to provide sufficient funding
for their ongoing business. This hoarding was aggravated by fear of counterparty
risk in the interbank market, due to other banks' undisclosed losses on
ABS from stresses affecting credit quality and the availability of liquidity.
Mark-to-market becomes a highly uncertain process when liquidity collapses
(ECB 2008), giving rise to concern that the assets of counterparties are mismeasured.
One consequence of these problems of funding liquidity was the failure of the
solvent UK mortgage bank Northern Rock, which had an aggressive reliance on
both wholesale funding and the securitisation of assets, which was no longer
feasible (House of Commons Treasury Committee 2008). In contrast, the US bank
Countrywide was able to rely on liability insurance contracts that limited
the scope for a run, a feature not present in earlier
crises.[11]

These combined features led to the emergence of historically large interest rate
premia – and quantity-rationing of funds – in the domestic interbank
markets in the United States, the United Kingdom and the euro area, at all
but overnight maturities. Funding at three months became particularly difficult
to obtain. In summary, these patterns in turn meant that funding liquidity
risk was closely related to market liquidity risk. Banks were vulnerable to
this linkage due to their low holdings of liquid assets, increasing reliance
on short-term wholesale funding, dependence on securitisation, backup lines
to SIVs, and the rise in overall maturity mismatch on their balance sheets
related to ‘repatriation’ of SIVs and
conduits.[12]

5.2 Relevant liquidity risk paradigms

In evaluating the sub-prime crisis, it clearly has elements of the standard liquidity
crisis paradigm (Tirole 2008), such as an aggregate liquidity shock (fall in
house prices), deterioration of underlying loan quality, fire sales (of ABS)
and runs (on Northern Rock and Bear Stearns). Moreover, the run-up to the crisis
showed the familiar signs of the procyclicality of financial markets (Borio,
Furfine and Lowe 2001). However, there were also a number of less familiar
elements.

I suggest that one helpful paradigm for the crisis is to reinterpret the concept
of liquidity insurance, central to the Diamond and Dybvig (1983) model in the
context of securities markets. Securities markets offer liquidity insurance,
but in a different way to banks, by increasing the ease with which assets may
be transformed into cash prior to maturity (Davis 1994; Bernardo and Welch
2004). Yields are generally lower in highly liquid securities markets, as investors
are more willing to hold a claim if they are confident of its liquidity. Unlike
at-call deposits at banks, there is no guarantee of a fixed rate at which securities
can be liquidated immediately, but short-term high-quality debt securities
provide a considerable degree of security. Meanwhile, so long as markets remain
liquid, the investor benefits from a shorter effective maturity than offered
by the issuer, thus there is again maturity transformation.

Like banking, however, market liquidity depends on all other holders not seeking
to realise their assets at the same time. If doubt arises over the future liquidity
of the securities market it is rational to sell first, before the disequilibrium
between buyers and sellers becomes too great and market failure occurs. That
is, prices are driven down sharply, and selling in quantity becomes extremely
difficult. Such collapses may result from a fear of deteriorating funding conditions,
which leads a number of investors to sell assets simultaneously before they
are forced to do so under fire-sale conditions.

A loss of liquidity in debt markets may have externalities similar to bank failures.
This may be particularly true if: there are leveraged investors who are forced
to sell despite such illiquidity; there is contagion between markets; illiquidity
makes investors unwilling to accept new issues; and there are debtors who do
not have an alternative source of rollover
finance.[13]
Note that all of these channels are relevant to the description of the sub-prime
crisis above, particularly with respect to the liquidity failure of the ABS
and ABCP markets. Following runs on these markets, the interbank market was
adversely affected, as banks that could not securitise – and had to finance
backup lines – hoarded liquidity. Such patterns were unprecedented, given
the enhanced role of banks as asset sellers and liquidity providers.

The nature of liquidity failure in securities markets is further clarified by analysis
of the role of market-makers, whose importance was again outlined in the description
above. The response of market-makers to ‘one-way selling’,
where the new equilibrium price is uncertain, is often simply to refuse to quote
firm prices, for fear of accumulating stocks of depreciating securities. This
contributes to a collapse of liquidity. Uncertainty is crucial; if there is
a clear new market-clearing price at which buyers will re-emerge, the market-makers
will adjust their prices accordingly. Such uncertainty was seen as a key feature
of the recent crisis, relating notably to structured products, which had no
price history to help predict behaviour under stress (Caruana and
Kodres 2008), and which also led to banks being unable to price their own assets.

The collapse of dealer markets, even in the absence of generalised uncertainty and
one-way selling, may result from perceptions of asymmetric information (Glosten
and Milgrom 1985; Kyle 1985). A rise in the share of insiders leads market-makers
to widen spreads to avoid losses. This discourages liquidity traders, who withdraw,
increasing adverse selection. Some dealers may cease to operate. Once the insiders
(with superior information) become too numerous, bid and ask prices may be
too disparate to allow any trade. Here I note that banks feared that others
were not disclosing their true losses on ABS, directly and via SIVs, so they
refused to lend on the interbank market. Equally, ABCP investors doubted the
value of assets in SIVs and so refused to finance them. In the case of either
one-way selling or acute asymmetric information, the asset market, in effect,
ceases to function. The associated decline in liquidity is likely to increase
sharply the cost of raising primary debt in such a market (that is, there will
effectively be heightened price rationing of credit), or it may even be impossible
to gain investor interest at any price (quantity rationing). The closure of
markets for securitisation fits this description.

The IMF (2008) argues that market liquidity collapses are particularly likely when
market-makers lack absorptive capacity, for example, due to costs of funding
inventory and internal capital limits, which will in turn relate to whether
returns to market-making are low. Gromb and Vanayos (2008) argue that there
is a feedback loop, as price falls hit the capital of dealers, making them
less willing to make markets. Indeed they may sell existing inventories, aggravating
the problem. Market liquidity collapses may also occur more commonly when there
is no clear order of trading, as in OTC markets, and when market-makers are
risk-averse (Bernardo and Welch 2004). There can also be spillovers between
funding instruments when firms are active in several markets, as market-makers
and/or arbitrageurs, as liquidity needs in one market lead to early liquidation of
assets in other markets.

Adrian and Shin (2008) also suggest that contagion during the current crisis differed,
in quite specific ways, from that in traditional liquidity crisis models. The
traditional view, as set out in Section 2, is that credit risk leads to contagion,
either via direct exposures or uncertainty over opaque balance sheets. In the
current world, Adrian and Shin argue that contagion
occurs via changes in market prices, according to the way that risks are measured
and the mark-to-market practices of financial institutions. Financial institutions
are seen to manage balance sheets actively in response to price changes and
measured risk. Moreover, this appears to have led to a positive relation between
changes in leverage of commercial banks and balance sheet size, as they have
taken on behaviour patterns hitherto more typical of investment banks.

In an upturn, when balance sheets are strong, banks see leverage as too low and seek
to expand balance sheets by increasing lending and incurring short-term liabilities.
This is seen as boosting aggregate liquidity across the economy as a whole,
facilitating lending to sub-prime borrowers in the run-up to 2007. As things
turn down, perhaps in response to an adverse shock to market prices (as occurred
due to heightened perceptions of credit risk and the collapse of market liquidity
in 2007), financial institutions that mark to market find their leverage too
high and seek to contract their balance sheets. Cifuentes, Ferrucci and Shin
(2005) note that fire sales of assets by distressed institutions may aggravate
such a pattern by further depressing market prices. Note the contrast with
traditional crises, in which a deterioration of credit quality would have no
immediate direct effect on the balance sheet, assuming that valuations are
based on book values. Mark-to-market creates a new and much closer link from
illiquidity to insolvency, since a loss of liquidity causes price falls that
impact solvency directly, leading in turn to further attempts to sell and further
price falls.

Adrian and Shin (2008) show that a pattern of desired reduction in leverage is precisely
what happened successfully in the LTCM crisis. However, the current crisis
is different because banks found themselves obliged to expand credit to cover
backup commitments for SIVs and conduits, due to the closure of the ABCP market.
Also, the closure of the ABS market meant that banks had to hold mortgages
they were issuing on balance sheet. In such a situation, it is argued that
they quickly cut back on discretionary lending, most notably to the domestic
interbank market.

A helpful complementary paradigm of funding liquidity that encompasses some of the
events of the 2007 and 2008
crisis is provided by Freixas, Parigi et al (2000). According
to this model, liquidity may dry up for a solvent bank in the interbank market
if there is imperfect information, or if there is market tension which reduces
the lending bank's excess liquidity and its scope to diversify. The interbank
market as a whole may face liquidity problems if each bank refuses to lend
to others because it cannot be confident of its own ability to borrow, a form
of liquidity crisis akin to the Diamond-Dybvig model.

Brunnermeier (forthcoming) talks of four mechanisms by which small shocks are amplified,
leading to a loss of liquidity. These are first, borrowers' balance sheet
effects comprising a loss spiral (as an initial loss on a leveraged balance
sheet leads to a decline in net worth, sales and price movements, further reducing
net worth) and a margin spiral (as increased margins lead to deleveraging and
sales, leading to lower prices, further increasing margins). Second is a lending
channel effect (notably precautionary hoarding of liquidity). Third are runs
on institutions and markets (including the interbank, ABCP and investment bank
repo markets). Fourth are network effects; for example, when Goldman Sachs
expressed concerns about exposures to Bear Stearns via swap netting arrangement,
hedge funds avoided Bear Stearns as a prime broker, thereby helping to bring
about its demise.

6. The LOLR and the Sub-prime Crisis

Besides needing a new understanding of the nature of liquidity failure in financial
crises, the recent turmoil has raised a number of issues for the traditional
LOLR role of central banks (described in Section 4 above), suggesting a need to amend the traditional
doctrine. These issues did not come into play in the same way in the otherwise
similar LTCM crisis (Davis 1999), where the resolution occurred largely via
a private-sector rescue of the hedge fund (albeit under pressure from the Fed)
and interest rate cuts by the Fed. Following the same order as Section 4,
I now go on to discuss issues relating to open market operations and individual
lending; the nature of open market operations; the widening of the safety net
from commercial banks; the issue of illiquidity and insolvency; conflicts with
other macroeconomic policies; collateral policies; private-sector rescues;
difficulties with information; reputation of banks and LOLR confidentiality;
interaction with deposit insurance; and international concerns. I conclude
by pointing out the issue of how authorities may exit from current LOLR policies.

I note at the outset that although the sub-prime crisis was seen as giving rise to
major risks, the operation has not (yet) involved the fiscal authorities in widespread
guarantees and bailouts as is typical of a major systemic banking crisis as
cited in Hoelscher and Quintyn (2003). I therefore concentrate on points raised
in the non-systemic discussion of current doctrine in Sections 4.1–4.3.

6.1 The sub-prime crisis and the nature of LOLR

Earlier I discussed whether open market operations or individual lending was most
appropriate for LOLR. For the most part during the current crisis, LOLR was
in the form of open market operations, but under unprecedented conditions.
Extreme tightness of the interbank market in all but overnight maturities had
not hitherto been a feature of domestic markets in advanced countries. Accordingly,
the Fed and ECB, in August 2007 and thereafter, intervened heavily to overcome
the liquidity crisis in the interbank markets – which had negated the
usual method of distributing liquidity around the banking system, including
to banks lacking access to open market operations. Note that such policies
do appear to be close to standard open market operations, but I contend that
the emergency operations cited were ‘LOLR-like’ in the sense of
being to satisfy short-term increases in the demand for reserve money, as opposed
to setting interest rates per
se.[14]

Owing to the interbank market difficulties, central banks such as the ECB also felt
the need to lend in open market operations at longer maturities than had hitherto
been the case. In the United States, the Fed introduced the term auction facility
(TAF), making funds available at longer terms than normal. This extension of
the maturity of liquidity assistance was a response to the weakness of the
longer-term interbank market and the banks' needs for such funding in the
light of the collapse of ABCP issuance and the demand for backup facilities.
It also meant that some players with adequate liquidity positions had even
more scope to hoard liquidity.

One puzzle in the current crisis is why it is so protracted given the amount of support
central banks have offered to markets and institutions. A key issue is of course
the underlying uncertainty about the valuation of assets on banks' balance
sheets. But, as Caballero and Krishnamurthy (2008) argue, there may also be
underlying uncertainty as to whether central banks have the liquidity and instruments
to resolve the crisis.

I noted in Section 4.1 that traditionally LOLR assistance has
been provided only to commercial banks. The Fed was forced to implicitly extend
safety net protection to include investment banks, incurring a balance sheet
guarantee for the Bear Stearns rescue via JPMorgan Chase. It also made emergency
liquidity available to investment banks more
generally.[15]
The Bear Stearns situation showed that some investment banks have become sufficiently
systemic to warrant such rescues, not due to the size of their balance sheets
but because of their central role in the markets for credit default and interest
rate swaps (Palmer 2008). Equally, however, some argue that Bear Stearns had
departed from the traditional model of investment banking by holding long-term
illiquid assets, making it particularly vulnerable to liquidity risk. Given
this precedent, and wider liquidity provision, investment banks are now accorded
unprecedented protection for their risk-taking activities, which is widely
seen as requiring tighter regulation.

6.2 The sub-prime crisis and the costs of LOLR

The role of markets in the current crisis made the issue of only lending to the illiquid
and not the insolvent a more complex one. In effect, central banks were at
times lending in order to reliquify markets (also via collateral as discussed
below) and only indirectly to provide liquidity to institutions. A market can
obviously not become insolvent but its liquidity can impact on institutions'
solvency, as the sub-prime crisis showed and Section 5.2 highlighted.

Conflicts with other policies loomed large during the current crisis. Central banks
injecting liquidity at times faced the challenge of not changing the overall
monetary policy stance in an undesired manner. Given the need for liquidity
at longer maturities than normal, sometimes this would entail central banks
withdrawing liquidity at shorter maturities to keep the monetary policy stance
unchanged. I note that there remained a challenge also to traditional interest
rate setting given the unprecedented and persistent spreads between LIBOR and
central bank rates, that made official rates a poor indicator of the true stance
of monetary policy (Martin and Milas 2008).

An unanswered question in the current crisis is how much moral hazard has been generated
by these ‘new’ LOLR policies. Certainly, aspects such as the extension
of the safety net to investment banks and the easing of collateral policies,
as discussed below, could have the effect of worsening moral hazard.

6.3 The sub-prime crisis and minimising costs of LOLR

It was noted that requiring good collateral is a key basis of the traditional doctrine
of the LOLR. Some central banks implicitly responded to the loss of market
liquidity in 2007 and 2008 by reducing collateral standards (accepting
residential mortgages, and even ABS). This in turn could be seen as reliquifying
the ABS market indirectly, in effect setting prices for those assets, as market-maker
of last resort. The Fed and the Bank of England
extended their lists of eligible collateral, the Fed including credit derivatives
in eligible collateral. Eventually the Bank of England set up a system of long-term
swaps for mortgages and ABS with government bonds, thought likely to total
over £50 billion, but only for assets already held on the banks'
balance sheets in December 2007.

This easing of collateral requirements is an inversion of traditional LOLR rules,
with central banks possibly accepting excessive credit risk (although the latter
is controlled by haircuts, notably by the Bank of England) and also potentially
encouraging banks to continue risky lending practices (if such loans can still
be used as collateral), and correspondingly justifying the banks' low levels
of liquid assets (Goodhart 2008a). Meanwhile, banks have the incentive to hoard
top-quality collateral, and central banks may risk becoming lenders of first
resort, facing adverse selection as banks have an incentive to offer up the
worst-quality assets as collateral. This was an issue for the ECB, which did
not expand its already extensive list of eligible collateral, but did find
that banks were undertaking ABS securitisations solely for ECB collateral (The
Economist 2008).

Doctrine states that private-sector solutions need to be sought in order that LOLR
policies avoid generating moral hazard. But in general these were not forthcoming
in the sub-prime crisis. Northern Rock had to be rescued by the Bank of England
and the UK government rather than a private-sector buyer being found. Bear
Stearns was only bought by JPMorgan Chase with a Fed guarantee. These cases
underline, on the one hand, the wide scale and scope of the problem, with few
banks feeling strong enough to step forward as buyers. On the other hand, they
also reflect the uncertainty about valuations, which may have hindered private-sector
buyers from stepping forward. In the case of Northern Rock, prospective buyers
in advance of the run were put off by the liquidity problems of the bank, as
well as the protracted process of takeover in the United Kindgom (House of
Commons Treasury Committee 2008, pp 51–52).

Adequate information was noted to be essential for efficient operation of LOLR. Northern
Rock presented a challenge for the United Kingdom's nascent tripartite
agreement. It was considered that the Financial Services Authority (FSA) did
not warn the Bank of England of the risk to Northern Rock in a timely manner.
Eichengreen (2008)
attributes such problems to differences in bureaucratic incentives and questions
whether separation of regulation and LOLR is appropriate. The United Kingdom
is introducing an enhanced role in financial stability for the Bank of England
to rebalance the relationship between the Bank of England and the
FSA.[16]

The loss of reputation for banks obtaining support, and the confidentiality of the
LOLR, has become an important issue (Goodhart 2008a). In the United Kingdom,
LOLR support was offered to the solvent bank Northern Rock as it had suffered
a loss of wholesale funding, on which it was heavily dependent, and it was
considered too big to fail. This support was planned to be announced by the
Bank of England, unlike its past behaviour to keep such interventions secret.
(It has been reported that the Treasury Solicitor gave advice that secrecy
was illegal under EU financial regulations.) However, the announcement was
pre-empted by a leak to the British Broadcasting Corporation on the previous
day. This is in stark contrast to earlier episodes when support was covert
and successfully
so.[17]
There followed a retail run which was only stopped by a government guarantee –
the bank was ultimately
nationalised.[18]
The internet facilitated the retail run in a manner that would not have been feasible
in the past, both via direct withdrawals and panic when the bank's website
crashed.

Particularly in the wake of this, banks were unwilling to access central bank lending
facilities, for fear of similar reputational risk. Rather they increased market
demands for liquidity, for example, via backup facilities, that may have worsened
the tight liquidity situation (IMF 2008). The responses to such reputational
issues, also present in the United States, included the TAF, whereby the Fed
made funds available not only at longer terms but also to a wider range of
counterparties and with a wider range of collateral. This was seen as not carrying
a stigma in contrast to discount window borrowing (the rate for which was meanwhile
reduced, contrary to traditional doctrine, to seek to avoid stigma).

The growing public awareness of limitations of the United Kingdom's deposit insurance
scheme was a feature in the Northern Rock case. This featured co-insurance
up to a low maximum sum, and no guarantee of a prompt payout. By its nature,
it seeks to provide protection from moral hazard, incentives to monitor and
a degree of consumer protection – not to protect against runs (Goodhart
2008b). The lesson is that LOLR may be called upon more often in such regimes
because of runs – but a comprehensive guarantee risks generating a lot
of moral hazard (and makes more urgent a bank insolvency regime for ‘prompt
corrective action’). Some would argue that it was deposit insurance problems
rather than systemic risk that motivated the Northern Rock rescue.

I noted above that the traditional LOLR was confined to the domestic banking system.
The crisis revealed that the traditional LOLR is unsuited to the globalised
banking system. This was evident in the lack of liquidity in US dollars for
European banks, following disruption in the foreign currency swaps market,
as underlying money markets dried up. This meant that banks were unable to
arrange liquidity to meet payment requirements in different currencies. This
was eased in December 2007 by cross-currency swap arrangements between the
ECB, Swiss National Bank and the Fed, linked to the TAF mentioned above.

It can be argued that the domestic focus of LOLR worsened uncertainty in the globalised
banking community, where banks have exposures in many currencies. Cooperation
between central banks had to be increased due to the need to avoid liquidity
support operations affecting domestic monetary conditions that could have influenced
the euro/US dollar exchange rate. Equally, there may be a need to avoid international
banks ‘gaming’ between different collateral requirements at the
major central banks (The Economist 2008), which may in turn necessitate further
coordination of collateral policy (FSF 2008). On the other hand, there was
not a major failure of a cross-border institution. In a future crisis,
such an event would severely test cross-border central bank and fiscal authorities
cooperation.[19]

Finally, the central banks face a challenge in terms of exit strategies from some
of the measures that have been adopted for the crisis. They will need to prevent
moral hazard, for example, by retightening collateral regimes to avoid banks
having long-run incentives to hold less, and lower-quality, collateral. They
will also need to ensure that the interbank market is reactivated, for example,
by reducing term lending facilities when they are no longer needed. The Economist
(2008) suggests that similar issues of generous LOLR holding back the revival
of publicly traded markets will arise for the European ABS market, which in
mid 2008 consisted mainly of securities for collateral with the
ECB.[20]

7. Conclusion

It is well known that liquidity risks are endemic to banks given the maturity transformation
they undertake. The first line of defence should be appropriate liquidity policy
for both assets and liabilities, supported by adequate capital and robust supervision.
Despite these, solvent banks can face liquidity difficulties at times of stress,
necessitating liquidity support.

As doctrine has developed, the role of the LOLR is to avoid unnecessary failures,
with suitable safeguards for central bank balance sheets and to minimise moral
hazard. The role of LOLR in crisis periods is to prevent contagious panic by
all means available – the central bank in such cases requires government
support. LOLR must be a temporary policy with restructuring of distressed banks
and corporate borrowers in the long term.

The current crisis has shown that traditional models of banking risk and of LOLR
require revision, as was already apparent to a lesser extent in the LTCM episode.
Funding risk now interacts with market liquidity risk to create difficult challenges
for central banks. Runs must be envisaged in markets and not just banks, which
given mark-to-market accounting, leads to threats to
the liquidity and solvency of banks via changes in market prices.

As a consequence, extensive changes to the traditional LOLR have been necessary,
including: longer-term funding provision with a variety of lower-quality collateral;
bringing investment banks into the safety net; and difficult challenges related
to confidentiality of bank support and the interaction with deposit insurance.
It is an important issue to investigate whether the net effect of these changes
has been to increase moral hazard, the Achilles heel of the safety net. There
also remains the unresolved issue of failure of cross-border institutions.

Beyond the scope of this paper, there is a further challenge to develop regulation
of bank liquidity so that the LOLR is not so essential in future episodes.
This could involve a liquidity adjustment to value-at-risk estimates to incorporate
maturity transformation, measurement of stock liquidity and appropriate market
and funding liquidity stress tests (Goodhart 2007; IMF 2008).

Footnotes

The author is Professor of Economics and Finance at Brunel University and a Visiting
Fellow at the National Institute of Economic and Social Research. (e-mail:
e_philip_davis@msn.com,
website: <http://www.ephilipdavis.com>). I thank Ray Barrell, Sumon
Bhaumik, Charles Goodhart, Christopher Kent, Tsuyoshi Ooyama and Marc Quintyn
for help and advice. I remain, of course, responsible for any errors.
[1]

The capital charge on credit lines to such subsidiaries was less than those of holding
the assets on balance sheet.
[9]

The corollary is that the potential scale of losses is exaggerated by using a mark-to-market
approach to value such illiquid securities (BoE 2008).
[10]

Goodhart (2007), however, notes that such liability insurance is not a resolution
for a systemic crisis, as it merely relocates liquidity risk.
[11]

Bradley and Shibut (2006) show that US banks' ratios of deposits to liabilities
fell from 93 per cent in 1965 to 60 per cent since 2000.
[12]

The parallels between banks and securities markets are not exact, since investors
who are not constrained to sell and do not suffer defaults do not make a
loss by ‘sitting tight’ and can still make a profit on their
portfolio of securities. In other words, markets, unlike banks, may become
illiquid but cannot become insolvent. Equally, the difficulties for issuers
arise only in the case that an existing issue of securities needs rolling
over – or there is a pressing need for a further issue – when
the liquidity problem arises.
[13]

Goodhart (1999) maintains that only support for individual banks should be termed
LOLR.
[14]

As set out by the UK Chancellor in June 2008, current proposals are: first, for provision
of a statutory responsibility for financial stability for the Bank of England;
second, changes to the governance structures of the Bank of England, to support
the Bank and the Governor in the exercise of these new responsibilities,
including the establishment of a new Financial Stability Committee of the
Court; and third, provision of a range of tools for the Bank of England to
enable it to carry out its responsibility in this area. This will include
a leading role in the implementation of the new special resolution regime
(SRR), should it be triggered by the FSA, with powers related to deploying
and implementing the SRR tools. These proposals will be included in the Banking
Reform Bill, to be introduced later in 2008.
[16]

The Bank of Japan faced similar challenges in 1998 when deciding not to offer LOLR
to the Long-Term Credit Bank of Japan, for fear of a loss of reputation.
However, in that case a merger was seen as probable if not certain (Nakaso
2001).
[17]

Further difficulties arose thereafter for the UK authorities owing to the lack of
a special insolvency scheme for banks.
[18]

As noted, the Fed accepts credit derivatives in liquidity operations while others
do not. The ECB allows for newly created ABS and the Bank of England restricts
access to its long-term liquidity to securities already on banks' balance
sheets as at December 2007.
[19]

The Economist quotes an estimate by JPMorgan that €320 billion in eligible mortgage-backed
ABS were created from August 2007 to June 2008 but only €5.8 billion
were placed with investors.
[20]

De Bandt O and P Hartmann (2002), ‘Systemic Risk in Banking: A Survey’,
in C Goodhart and G Illing (eds), Financial Crisis, Contagion, and the Lender of Last
Resort: A Reader, Oxford University Press, Oxford, pp 249–297.

Gatev E, T Schuermann and PE Strahan (2006), ‘How Do Banks Manage Liquidity
Risk? Evidence from the Equity and Deposit Markets in the Fall of 1998’,
in M Carey and RM Stulz (eds), The Risks of Financial Institutions, National Bureau of Economic
Research Conference Report, University of Chicago Press, Chicago, pp 106–127.